Thursday, February 2, 2012

Negative stimulus, 1946

I ran across a fascinating article, "A Post-Mortem on Transition Predictions of National Product," in the 1946 Journal of Political Economy, by Lawrence Klein. Klein, who would go on to create the main macroeconomic forecasting models and a Nobel Prize, was confronting one of the first great failures of Keynesian economics:

We all recall clearly the headlines in last Autumn's press, declaring that "Government economists predict 8 million unemployed by 1946." ...We now find ourselves in the first half of 1946 with about three million unemployed and facing one of the greatest inflationary pressures that we have ever experienced. The economists who were warning us of a deflationary danger during the early months of the postwar transition period should have been stressing precisely opposite economic policy

Yes indeed. Government spending, or "stimulus" in the modern lingo, was certainly going to fall like a stone at the end of the war. 8.5 million young men would be dumped on the labor market. With a Keynesian mindset the forecast was obvious: we're going right back to the depression. Instead, we got sharp inflation and a boom.Where did they go wrong? This event has been covered in more depth, but let's keep reading Klein's analysis...

The customary model for prediction can be called the simplest Keynesian model...The model can be written as GNP=C(GNP)+I, where GNP = gross antional product, the function C(GNP) is the consumption schedule, and I = autonomous investment....

It is immediately obvious where this forecast failed-in the prediction of consumer expenditures,...The order of magnitude of the error involved is great, and, what is more serious, it is great enough to lead to disastrous policy recommendations. The predicted GNP of $164.5 billion should call for an inflationary policy, but this is just the opposite of the policy that was needed...

Most critics will agree that the consumption function is incorrect...At least as important as the statistical errors, however, are the errors of economic theory...[the consumption function].may be incorrect from an economic theoretical point of view and from a statistical point of view.

And after this poor Klein dithers around with statistics, the special effects of "bottlenecks," wartime, liquidity and so on. With the benfit of hindsight you can see him circling around the elephant in the room, the permanent income theory of consumption. No, returning soldiers did not follow some "schedule" relating this year's consumption to this year's income. He's so close, he can smell the elephant, but he never quite touches it. That would wait 15 years and Milton Friedman's permanent income, to be followed by Lucas, Sargent and the others who tore apart this Keynesian castle.

Why are we reading this? It's fun to go back and see how really smart people understood things at the time. Maybe it should give us some humility -- so much policy debate seems based on the idea that we know everything so well. If we understood things as well as we now see Klein understood things, would we still want to spend trillions on our best guesses? Klein is happy that the Government didn't follow the widely-recommended "inflationary" or stimulative policy advocated in 1945! If you were transported back to to 1790 and got sick, would you want to be treated by the best doctors of the day?

On the other hand, many of Tom Sargent's writings suggest our ancestors understood nuances of policy even better than we do -- or at least before the brief interlude in which Keynesians forgot everythng their ancestors knew. (Start with Tom's Nobel Prize speech. The point is not that hard to see between the lines.)

As a research economists, it's a bit frightening. There are surely such elephants in our room that we're missing, and we will kick ourselves for not really noticing them. Try not to get so close and miss the big point!

I got to Klein on a different mission. 1946 is a great data point to understand -- the great negative stimulus which coincided with a boom and inflation. I also got to this paper while digging in to the long set of historical writings that found budget constraints missing in Keynesian models. This is a big point in my writings about stimulus, but I'm not the first to notice that. More later...

Notice a Journal of Political Economy article published in August 1946 about how summer 1945 forecasts for 1946 turned out! That could never happen now, in any academic journal.

21 comments:

Is this because today the process (writing the article, getting it peer-reviewed, having a journal accept it, then delay to publication) is much slower? If so, do you have any idea why this is the case? Or is it that academic journals now have more of a circle-the-wagons mentality? Or is it for some other reason not readily apparent to this outsider to academia (albeit one who, even after college, still downloads and reads the occasional article when he can find a free copy)?

You write, "Maybe it should give us some humility -- so much policy debate seems based on the idea that we know everything so well."

Why don't you practice what you preach and start by taking out the following phrase (and all your other digs and personal criticisms of Keynes):

the first great failures of Keynesian economics

Instead, look at the situation with a little understanding or humility, understanding that a wise man changes his mind often and a fool never.

Close to the end of his life Keynes remarked that he was still thinkging. Just before his death in 1946, Keynes told Henry Clay, a professor of Social Economics and Advisor to the Bank of England of his hopes that Adam Smith's 'invisible hand' can help Britain out of the economic hole it is in: "I find myself more and more relying for a solution of our problems on the invisible hand which I tried to eject from economic thinking twenty years ago."

Predictions that we would have unemployment and deflation at the end of the War were not Keynesian, they were classical and shared by most everyone.

People knew the numbers of men in the armed services who were going to be discharged. They had within short memory experienced massive unemployment and had been unsuccessfull in finding any solution. Now, it seems to me that expecting unemployment and deflation wasn't that off based.

As for why not, respectfully, I would suggest that your explanation is not the answer.

From such charts as are available to me, as well as I can read them, private debt expanded and was the key driver in preventing the expected contraction.

As you know, we may have had a similar period of prosperity starting in 2001 when private debt and mortgage equity withdrawals masked real declines elsewhere.

In sum, drop all the attacks on Keynes, all the silly metaphors like Keynesian castles. You might find some common ground were we could make progress.

Take me for example. I am a Keynesian, but the more I consider the matter, the more I believe that the problem with Keynesian solutions is its moral hazard. I can see where both political parties have refused to do what was right because they knew bases could be covered with Keynesian deficits. The worst offenders have been Republicans, especially Deficits Don't Matter Cheney. (Where was Cochrane?)

As for MF, Lucas, etal, leave them out. An idea or INsight is either useful or it is not. When you attach an idea to a person it only leads to a personalty cult, counter-cult, etc.

JLD, his justified criticisms of Keynes are based on looking at how its has performed historically, what he is suggesting is that future policy directives/debate should experience humility... apples and oranges mate.

JLD, Cochrane is practicing what he preaches. I don't claim to be able to speak for a leading economist, but the gist is that in light of the fact that we don't "know everything so well," it is best to let markets work, rather than continue to make wild guesses in the dark, which is the nature of Keynesian policy, and government direction of resources in general. We have a tremendous amount of historical data along those lines, including the ridiculous Keynesian predictions about the way the economy would fare in the aftermath of WWII. You rightly point out that Keynes largely reversed himself towards the end of his life, and for good reason.

The economic policies that George Bush and Dick Cheney adapted at the outset of the recession were unquestionably Keynesian. TARP, the Bush Paulson stimulus, the Foreclosure tax relief bill, etc. were all programs that received largely bipartisan support, and would undoubtedly be considered Democratic programs in the current political environment. Obama's economic policies, while more extreme, were ideologically indistinguishable. It is wholly backwards to assign the GOP disproportionate blame.

Classical economists would not have advocated stimulus in the wake of WWII, nor would they have at the outset of the present crisis. Other than Krugman and a few other fringe leftists, even most self identified Keynesians aren't advocating for more stimulus under present circumstances. There are also real distinctions between Keynesian economics and Classical economics, and they should be debated on their own merits, not on the basis of political happenstance. Nixon was a Republican, but his Keynesian policies had the same disastrous effects as Obama's, Bush's, Carter's, and FDR's, and there's no reason to suspect that government will do a better job directing resources next time, regardless of which party is in charge.

Ok, let's listen to the market because markets are more efficient at using all available information than governments are. The market is telling us that it is willing to lend US government money at negative real interest rates. In other words, the market wants to PAY US government to take its money. So doesn't this mean the market, as the most efficient information aggregator available to US, analyzed all the information and decided it wants US government to smooth consumption, create stimulus, invest the money, whatever terminology you prefer - but the market wants Government spending money. What do you make of that ?

Agreed -- I can't figure out how a reasonable person can look at the trillions of dollars worth of needed infrastructure repairs in the US, and the millions of unemployed construction workers, and conclude that the best policy is to do nothing (or even worse, to cut public spending). Fiscal stimulus may not be necessary or helpful in normal times, but these are not normal times.

You can't ignore the fact that large financial institutions that are required to hold cash can't simply deposit it at a local bank. Given the need to hold cash, the need to insure that the cash is available when needed, and the lack of other "risk-free" assets, it is understandable why some might pay a negative interest rate, assuming the rate is negligible. If my only two options available for deposit of my kid's college money that I need for this fall are a potentially risky asset or one that charges me a nominal fee but "guarantees" return of principal, then it makes sense, and it should not be interpreted as the market requesting more government spending.

I see what you are saying, but that doesn't explain why as we've had more and more stimulus etc., the rates have moved lower and lower. You can interpret it however you want, but the market is currently willing to pay US govt to take its money. People can buy stocks, gold, corporate bonds, etc. They can hold cash. There are plenty of liquid investments in the world that allow you to avoid negative real yield investments, such as a 10 year treasury. Also, only 4-5 years ago rates were highly positive. Presumably 4-5 years ago people were sending kids to college as well.

Once we see something that the market is doing that makes no sense, then we start inventing after the fact explanations. So we need to make up our minds - is market the most efficient alternative we have at aggregating all available information or not ? if not, there is room for other things. If yes, well then, I am confused by negative real yields on 10yr bonds

I think you missed the part where I said "large financial institutions". Also, don't confuse liquid with safe. Liquid means you can easily trade it; it doesn't mean it can't drop in value (ask Lehman shareholders). As to your point about "...4 - 5 years ago...", it is irrelevant to the discussion. You're trying to explain why rates are negative, which is abnormal. The fact that rates were positive, and historically are almost always positive (talking nominal vs real), doesn't need explaining.

it is unfortunate that a great deal of useful information is wrapped in such a polemic. the result is a paper of little usefulness.

from the information presented I would conclude:

1) federal debt doesn't matter (federal debt was 150% of GDP in 1946)

2) what does matter are: (a) the level of private debt, which was low, and the ability of banks to expand private lending to meet loan demand; (b) broad based private savings matter; and (c) work force attitude and skills matter---those returning GIs had abundant skills and great morale

if we took the lessons of 1946 seriously, our first priorities would be to find some to reduce private debt, down to a level where people could "prudently" borrow (whatever that means)

our second priority would be to concentrate on deepening and broading private savings (raising taxes on carried interest and lowering taxes on savings deposits)

And, most importantly, we would be spending more on education and stop attacking the morale of our workers (ending imports, stopping attacks like those in Wis. and Ind., etc.)

Correct Nancy. It was a most unusual time and circumstance. about two million people came back from either war, or war related work and got married and had a lot of kids. They needed all the things that people could not get during the war because of rationing.

In addition we had to also supply most of the needs of the rest of the world because the other economies had been so crushed due to war and war debt.

It was a unique time, and anyone who advocates policy today based upon that time period is just showing ignorance.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

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About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a professor at the University of Chicago Booth School of Business, a Senior Fellow of the Hoover Institution, and an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!